EEQUITY QUITY PPORTFOLIOORTFOLIO

MMANAGEMENTANAGEMENT

Portfolio Management

Ali Nejadmalayeri

Equity Management

• Indexing– Only changes in the index causes the portfolio

composition to change; e.g., additions/deletions

• Active– The goal is to beat a “benchmark” portfolio;

SP400, SP600 Growth, RUSSELL 2000, etc.

• Semi-Active– Also known as “Enhanced Indexing” or “Risk-

Controlled Active Management” aspire to beat a benchmark but limit tracking error

Tracking Error

• Tracking Error– The difference between a portfolio’s performance

and a benchmark’s

• Tracking Error Volatility– The variation of tracking error over a period

• Information Ratio– The ratio of tracking error over its volatility– Also, known as alpha to sigma ratio; alpha being

the abnormal excess return and sigma being its volatility

Examples of IR

Indexing Enhanced

Indexing

Active

Expected

Return

0% 1% − 2% 2%+

Tracking Risk

< 1% 1% − 2% 4% +

Information

Ratio

0 0.75 0.50

Passive Management

• Full replication– Reconstruct the index exactly

• Challenges: transaction costs, administration costs, cash-flow management, cash holdings

• Stratified sampling– Find dimensions of separation (size, value, etc.)– Select few stocks in each dimension

• Optimization– Optimize tracking error using multi-factor models

• Factors: size, beta, industry, interest rate, etc.

Indexes

• Price-weighted– Represent buy/hold return of 1 share; like DJIA, add all

prices correct for splits and composition

• Value-weighted– Represent buy/hold return of all shares of the index; like

SP500, add all market-values correct for composition• Sometimes the index is float-adjusted; supply of shares matters

• Equal-weighted– Represent buy/hold return of equal dollar amount invested

in each component; like ValueLine, add all return correct for composition and valuation drift

Examples of Indexers

• Conventional Index Funds– Net asset value determined daily

• ETFs– Buy and sales happens all the time; more tax

efficient than index funds; more transaction costs and licensing fees than index funds

• Separate pooled accounts– Mostly institutional clientele

Active Management

• Chose a style i.e. benchmark

• Beat the benchmark

• Get paid!

Equity Style

William Sharpe’s classification:• Large Cap Value

– Low P/E, Contrarian, high yield

• Large Cap Growth– Consistent growth, earning momentum, GARP

• Mid Cap– Blend or core approach

• Small Cap– Micro-cap

Style Index

• Indexes need to be:– Mutually exclusive

• No or limited overlaps

• Unique opportunities

– Exhaustive with respect to investment universe• Union of all indexes should encompass all assets

– Distinct sources of risk • Sources of variations in returns are for most part unique

• Value vs. Size

Style Identification

• Return-based style analysis – How different style indexes contribute to return– Determine how much selection contributes

• One minus coefficient of determination (RSQR) is selection contribution

• Holding-based style analysis – Valuation levels, Forecasted EPS growth, Earning

variability, Industry sector weightings

Return-based Style Analysis

• Advantages:– Characterizes entire portfolio– Facilitate comparison across portfolios– Aggregates the effect of investment process– Clear theoretical basis and limited minimal inputs– Quick and cost effective

• Disadvantages:– Maybe ineffective in characterizing current style– Sensitive to definition of style indexes

Holding-based Style Analysis

• Advantages:– Characterizes each position– Facilitate comparison of individual positions– Captures changes in the current style quickly

• Disadvantages:– Does reflect many portfolio managers approach

security selection– Sensitive to classification attributes for styles– More data insensitive than return-base analysis

Semi-Active Management

• Derivative-based– Provide desired exposure to different segment of

the market via derivatives• Equitize cash: long futures while holding cash

• Stock-based– Generate alpha (excess return) thru selecting

stocks that outperform the index while controlling risk (limiting exposure to industries, sectors, etc.)

What to Look for?

• Grinold and Kahn’s Fundamental Law of Active Management

• IR is the information ratio

• IC is the information coefficient or what you know about an investment decision

• Breadth is the number of independent investment decision in a year

BreadthICIR

Portfolio of Managers

• Examples are pension plans and other large institutional funds

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Return Active Portfolio

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22Risk Active Portfolio

Portfolio of Managers

• Core-SatelliteCore-Satellite– A large core portfolio perhaps in index funds and

semi-active funds plus satellite funds to add value thru active management

• The index and enhanced index funds should resemble that of the investor’s benchmark asset class

• The active fund can pegged against either the overall investor’s benchmark (that would make it more restrictive) or pegged to their own benchmarks

Core-Satellite Performance

• Performance has two dimension:– Manager’s “true” active return = Manager’s return

minus Manager’s Normal benchmark– Manager’s “misfit” active return = Manager’s

normal benchmark return minus Investor’s benchmark

• Manager’s active risk has also two parts:– Manager’s total active risk =

[(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk)2]½

Portfolio of Managers

• Completeness FundCompleteness Fund– Construct a portfolio of active managers that has

an overall risk exposure as the investor’s benchmark

• Such an approach limit the amount selection value

• Alpha & Beta SeparationAlpha & Beta Separation– Obtain desired beta from an index fund and then

the desired alpha from a market neutral fund• Not all long-short strategies are market neutral and

shorting is a costly activity

Good Managers

• Universe of suitable managers– Use data, consultants and resources to sort it out

• Past performance– There are no predictive power for past

performance, hence “past performance is no guarantee for future results”

• Fee Structure– Ad valorem vs. performance-based – Fee cap and high water mark

Equity Research

• Buy-side– Performing equity research with the intention of

actually managing equity portfolios; e.g., research departments in mutual funds

• Sell-side– Performing equity research for the purpose of

selling the results to generate business; e.g., independent research firms like S&P, Moody’s, ValueLine, etc.